March 2012 Equity Commentary

Accommodative Monetary Policy continues to Support U.S. Equities Rally

Continuously improving economic data in the U.S., aggressive accommodative monetary policy by central banks around the globe, and some stabilization in the European sovereign debt crisis continued to support the U.S. equity market rally in March. For the month, the Standard and Poor’s 500, Russell 1000, and Russell 2000 indices returned 3.29%, 3.13%, and 2.56%, respectively. At the same time, in a sign that that U.S. may be “exporting” the recessionary pressures outside its borders, international equity markets underperformed with the MSCI EAFE and MSCI Emerging Markets indices returning -0.40% and -3.32%, respectively. Having said that, equity markets around the globe have rallied hard off their lows posted in the fall of 2011, albeit on low volume, and 2012 year-to-date returns through March were in the low- to mid- double digits, depending on the region. Growth stocks did better than value names for the third consecutive month, with the Russell 1000 Growth Index returning 3.29% vs. the Russell 1000 Value Index’s 2.96% advance. For the year to date, the Russell 1000 Growth Index is up 14.69% compared to the Russell 1000 Value Index, which is up 11.12%.

Within the Russell 1000 Index, financials, information technology, and healthcare were the top-performing sectors during the month with financials, information technology and consumer discretionary the top three performing sectors year to date. The energy, materials, and industrials sectors lagged in March with utilities, telecommunication services, and energy now the worst performing sectors year to date.

Positive U.S. Economic Data Continues

U.S. economic data continued to be positive and improving in March. Strong regional manufacturing surveys during the month, including positive surprises by both the Empire State Manufacturing Index and Philly Fed Manufacturing Index, suggested the national manufacturing PMI should increase as well. The release of the ISM National Manufacturing PMI at the time of this writing confirmed this expectation, with the figure rising to 53.4 in March from 52.4 in February.

A low dollar, thanks to the especially accommodative monetary policy in the U.S., continued to help U.S. exports and support the rebuilding of the domestic manufacturing and industrial base. However, more recently the service sector has been showing signs of improvement as well. The ISM non-manufacturing index data reported in March indicated that during February, service industries expanded by the most they had in a year—a sign the manufacturing-led recovery in the U.S. may be spreading to other sectors. Durable goods orders rose less than expected in February. While retreating from high levels, these numbers were still firmly in expansionary mode. Although manufacturing may give up its status as the main driver of economic growth once the consumer recovery accelerates further, that transition will be a much needed and long-awaited development for the U.S. economy.

Employment data trends were also reassuring with payroll growth and household employment growth very strong, which may be a reflection of new small business formation in the U.S. Initial jobless claims fell to their lowest level since June 2008, with the four-week moving average down to 365,000. Although the unemployment rate remained at 8.3% in the most recent Labor Department report, we would have seen another incremental improvement in the unemployment rate had the workforce participation rate not increased slightly. The U.S. unemployment rate is likely to remain stubbornly high for some time given the tepid economic growth in this country. Nevertheless, improving employment data will continue to be extremely important for the U.S. economic recovery and sustaining improvements in consumer confidence.

Overall, the U.S. economy seemed to be on the path to self-sustained recovery with the index of Leading Economic Indicators (LEI) increasing for the fifth consecutive month. As investor consensus moved further toward economic expansion in the U.S., the selloff in Treasuries continued, with the 10-year yield increasing 25 basis points in March; though at the time of this writing the yield has fallen back to below 2%.

Housing Market Stabilizing

The U.S. housing market continued to stabilize in March with activity picking up and prices continuing to bottom out. While the sector hasn’t yet posted a rebound, it appears that it is not as much of a drag on the economy.

Improvements in consumer data supported the notion of improvements in housing market activity. Data from home builders showed considerable improvement despite the Mortgage Bankers Association Mortgage Applications Index declining throughout the month, as the share of applicants seeking to refinance dropped to an eight-month low. Housing starts were near a three-year high and building permits increased by 5.7% in February. At the same time, the inventory of unsold homes increased in February.

Pending home sales fell 0.5% in February but were up a healthy 13.9% on a year-over-year basis, while sales of existing homes hovered near a two-year high, indicating an overall improvement in housing market activity despite continued softness in housing prices.

Gasoline Prices Getting Higher

Unfortunately for the global economy and consumers, the rate of increase in oil prices kept pace with the stock market. This rising oil price trend, if not reversed, will likely put a damper on global economic growth. There is a natural boost to oil prices as economic activity improves and fuel consumption increases; however, the price increase this time is exacerbated by the geopolitical tensions in the Middle East, where Iran’s nuclear ambitions are once again in focus.

The consumer sector seemed to be performing well despite elevated oil and gasoline prices. Consumer confidence data reported during the month indicated consumers were not as heavily impacted as they might have been had the stock market and the job market not been improving. Vehicle sales remained strong and February chain-store sales numbers reported during the month also exceeded expectations. Not surprisingly, we are seeing a pick-up in consumer spending, which increased 0.8% in February—the largest gain in consumer purchases since July 2011. At the same time, consumers saved a bit less, with the personal savings rate falling to 3.7% from 4.3% in January.

Accommodative Monetary Policy Continues

Investors interpreted Fed Chairman Ben Bernanke’s speech on March 26 as “dovish,” with his comments on the labor market reaffirming the need to maintain a low interest rate environment to stimulate economic and job growth, while also keeping alive hopes of a third round of quantitative easing (QE3).

However, if the U.S. economy continues on a path to recovery at the current or better pace, QE3 won't be necessary, and could possibly be harmful, as excess supply of cheap money tends to create speculative bubbles that hurt the economy in the long run. The Federal Reserve Flow of Funds report for 2011 indicated the Fed purchased 61% of total net Treasury issuance last year, compared to minimal amounts before the financial crisis. This aggressively accommodative monetary policy is likely to create an environment conducive to imbalances and bubbles in the global economy and markets. With U.S. interest rates and the dollar at historic lows, U.S. dollar-denominated commodities like oil have been rising in price to levels where the demand destruction begins to create negative feedback on both commodity prices and economic growth globally. Interestingly, this negative feedback may be disproportionately higher for the commodity-hungry emerging market economies than for the U.S. itself. Therefore, it could be that the U.S. will end up "exporting" the recessionary pressures outside its borders to more commodity-intensive economies like China, where data indicated industrial profits fell 5.2% through the first two months of 2012 compared to the same period one year ago. Brazil and Australia, who export heavily to China, also saw GDP growth slow considerably in the fourth quarter of 2011.

China’s Economic Growth Slows

China cut its economic growth target from 8% to 7.5% during the month, signaling the country’s need to transition to a more sustainable, consumer-driven, economic model. A slower inflation trend allowed the Chinese government to continue to reposition its economic policy from contractionary for most of 2011 to stimulative.

Nevertheless, the Chinese economy continued to decelerate in March as foreign direct investment (FDI), one of the major drivers of economic growth in China, declined on a year-over-year basis for the fourth consecutive month. Increasing domestic consumption in the country will be key to offsetting this effect. In a slower growing economy with no healthcare insurance or retirement system and a very high savings rate as a consequence, as individuals save to provide for these services themselves, it is unclear whether consumer spending will be able to fully compensate for the drag on growth from reduced FDI and exports. China’s HSBC Flash Manufacturing PMI fell 48.1 in March, indicating a further slowdown, while retail sales in China also increased less than expected on a year-to-date basis.

A potential sharp slowdown or, more importantly, a hard landing in China, fueled by a possible burst of a real estate bubble there, will certainly create strong ripple effects throughout the global economy, especially other emerging market economies that supply into China, like Brazil and Australia. As for the U.S., this indirect impact may be less damaging than a domestic recession.

This dynamic will not help the eurozone either as it is a laggard with respect to its own low interest-rate policy and may not be able to fend off a more severe and possibly more prolonged recession such as the one the U.S. has had to contend with. Italy’s $9 per gallon gasoline prices will certainly have a negative impact on consumer demand and confidence. Higher gas prices may have this impact on the U.S. consumer as well, although at a national average of just under $4, gas prices are less onerous than in Europe.

Eurozone Sovereign Debt Crisis

In the eurozone, things were quieter for the moment. The Greek bond swap continued to move along with more than 80% of private creditors agreeing to participate in the debt swap that reduced the debt’s face value by about half. With the collective action clauses (CACs) under Greek law forcing the holdouts to join the bond swap, the total participation rate is around 96% and reduces Greece’s debt burden by 100 billion euros. However, the International Swaps and Derivatives Association (ISDA) determined Greece’s use of CACs constituted a credit event, which triggered credit default swap payments totaling $2.89 billion. Even with the bond swap, Greek debt is becoming an increasingly larger percentage of GDP due to the rate at which the country’s GDP is contracting. This trend will continue to jeopardize the country’s credit health.

The bond swap cleared the way for the 130 billion euro rescue package from the eurozone bailout fund and allowed the IMF to approve the release of additional funds for a Greek bailout as well. However, some IMF members remained skeptical of a Greek economy rebound and the idea of throwing “good money after bad.”

Despite the positive impact of the LTRO (Long Term Repo Operation), Europe continued to provide a negative backdrop to investor confidence and was a drag on the global economy. Eurozone GDP contracted 0.3% in the fourth quarter of 2011, while the unemployment rate in the eurozone reached a 15-year high of 10.8%. The fiscal drag started to have a pervasive negative impact on economic growth throughout Europe with core economies coming under stress during the month as well. The European Union (EU) forecasted the Dutch economy to contract 0.9% this year, primarily due to the implementation of tough austerity measures. During the eurozone sovereign debt crisis, the Netherlands was considered one of the stronger “core” economies, but now the EU projects only Greece, Portugal, and Spain to perform worse. Moreover, both German and French manufacturing PMI declined significantly in March, leading the drop in eurozone aggregate manufacturing PMI to 47.7 in March.

These data confirmed our concerns about the economic outlook for the eurozone and the stronger recession in Europe, including the core economies. Meanwhile, concern that Portugal won’t be able to access markets for financing and will require a second bailout increased throughout the month while widespread protests in Spain at the end of March highlighted the public’s opposition to another round of austerity measures.

No QE3 May Be a Good Thing

As the U.S. economy continues to improve, justifications for QE3 weaken. Paradoxically, this is disappointing to the investors who seem to prefer a sure and quick (however short-lived) policy-driven shot in the arm to an organic, self-sustained, but more painful long-term economic recovery. We clearly prefer the latter. This will in turn boost expectations for higher interest rates. At these levels, we may see some consolidation in the equity markets in the short to medium-term before any further upside.

Despite subdued recovery in the consumer sector and tepid income growth, the self-sustained recovery in the U.S., while slow, will likely create a positive feedback loop through the high multiplier effect stemming primarily from the economy’s manufacturing and industrial segments.

Political Stalemate in Washington Likely to Continue to Be a Drag

As 2012 marches on towards the presidential election, the key policy event to watch is what could be the most important predictor of GDP growth for 2013—the fiscal drag from the expiration of both the Bush tax breaks and the payroll tax cut extension on January 1, 2013, with possible negative impact on economic growth of as much as 4%. If a bipartisan solution to the issue is not found in time this would effectively raise taxes while government spending is cut.

Volatility is Here to Stay

Overall, the European sovereign debt crisis continues to evolve, although so long as it continues to resolve itself in a somewhat orderly fashion, we believe that it is unlikely to derail a U.S. economic recovery.

If a U.S. economic recovery proves robust enough to withstand the negative headwinds from Europe and China in 2012, U.S. equities may significantly outperform Treasuries, given the relative valuation of the two asset classes. Highly bid-up, dividend-yielding securities may also underperform as investor risk aversion subsides. However, if more investors refocus on the underlying economic fundamentals in Europe, the risk aversion trade may return for some time during the year. In this environment, despite stronger economic data in the U.S., one thing is most certain—equity market volatility is likely to be here to stay for most of 2012.

With such strong returns in the equity markets so early in the year, we would not be surprised to see a temporary pullback in equities, especially if some of the negatives in the global economic picture come into focus. From an absolute return standpoint, gains in equity markets achieved through the end of the first quarter of 2012 are attractive enough that, given the lingering negative backdrop from Europe and rising oil prices, some investors may choose to take profits and wait for new positive catalysts, like the upcoming earnings season, to re-enter the “risk-on” trade.

This commentary represents the opinions of the author as of 4/13/2012 and may change based on market and other conditions. These opinions are not intended to forecast future events, guarantee future results, or serve as investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information.

Accounts managed by Calvert Investment Management, Inc. may or may not invest in, and Calvert is not recommending any action on, any companies listed.

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